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Circular Like-Kind Exchange Disallowed

The Tax
Court disallowed tax-free treatment for a like-kind exchange
transaction in which the taxpayer exchanged properties with a
related entity.

Background

Ocmulgee Fields,
Inc. (OFI) is a corporation that develops, owns, and manages
real estate, owned by Charles Jones, his sons Dwight and Jeff,
and a partnership owned by the three men. Treaty Fields was a
limited liability company in the business of real estate
development owned by Dwight and Charles Jones.

In 2003,
OFI entered into an agreement with an unrelated third party to
sell a property known as the Wesleyan Station Shopping Center.
In order to complete the sale as a like-kind exchange, OFI
assigned its rights to sell Wesleyan Station to Security Bank as
a qualified intermediary for OFI in the sale. Security Bank sold
Wesleyan to the third party per the agreement.

After
looking at several properties owned by unrelated parties, OFI
decided to purchase Barnes and Noble Corner, which Treaty Fields
owned, as a replacement property for Wesleyan Station and signed
a sale contract with Treaty Fields. OFI had sold Barnes and
Noble Corner, which was part of the Rivergate Shopping Center,
to Treaty Fields in an earlier transaction. OFI continued to own
the rest of the Rivergate property. OFI transferred its rights
in the contract to Security Bank and received title to Barnes
and Noble Corner.

Treaty Fields reported the sale of
Barnes and Noble Corner as a taxable sale. OFI reported its sale
of Wesleyan Station and its purchase of Barnes and Noble Corner
as a like-kind exchange. The IRS issued a notice of deficiency
to OFI based on the transaction, claiming that OFI had
structured it in order to avoid tax by circumventing the Sec.
1031(f) prohibition on like-kind exchanges directly between
related parties. OFI challenged the IRS's determination in Tax
Court.

Sec. 1031

Under Sec. 1031, no gain or
loss is recognized on the exchange of property held for
productive use in a trade or business or for investment solely
for property of a like kind that is to be held either for
productive use in a trade or business or for investment. Under
Sec. 1031(d), the basis of property acquired in a Sec. 1031
exchange is the same as the basis of the property exchanged,
decreased by any money the taxpayer receives and increased by
any gain the taxpayer recognizes.

A special rule applies
in the case of exchanges between related parties. If a taxpayer
exchanges property with a related person and within two years of
the last transfer that was part of the exchange the taxpayer or
the related person disposes of the property received in the
exchange, nonrecognition treatment is not allowed. This special
rule does not apply if the taxpayer can establish "that
neither the exchange nor the disposition had as one of its
principal purposes the avoidance of Federal income tax"
(Sec. 1031(f)(2) (C)). However, if a taxpayer structures a
transaction to avoid the purposes of Sec. 1031(f), Sec. 1031
will not apply.

The Parties' Arguments

The IRS
argued that the case is governed by the Tax Court's decision in
Teruya Bros., Ltd., 124 T.C. 45 (2005), a case with a
similar fact pattern. In that case, the Tax Court found that the
taxpayer included a qualified intermediary in a transaction in
an attempt to circumvent the rule prohibiting an exchange
directly between related persons, and the taxpayer failed to
show that tax avoidance was not one of the principal purposes of
the transactions. The Tax Court therefore held that the
transactions were structured to avoid the purposes of Sec.
1031(f) and the taxpayer was not entitled to nonrecognition
treatment under Sec. 1031(a)(1).

OFI argued that it did
not structure the transaction to avoid Sec. 1031(f) because it
originally had intended to exchange Wesleyan Station for
property owned by a third party and it had a valid business
purpose for exchanging for the Barnes and Noble Corner property.
According to OFI, having failed to find a suitable property
owned by an unrelated party, it chose the Barnes and Noble
Corner property because reuniting it with the related property
it owned in Rivergate Shopping Center would yield operating
efficiencies and would increase the overall value of Rivergate.

Tax Court's Decision

The Tax Court found that in
order to determine whether petitioner's exchange with Security
Bank was part of a transaction or series of transactions
structured to avoid the purposes of Sec. 1031(f), it was
required to disregard the actual exchange and consider what the
results would have been if OFI had instead exchanged Wesleyan
Station with Treaty Fields for the Barnes and Noble Corner and
Treaty Fields had then sold Wesleyan Station. In making that
larger determination, the court was required to determine
whether, under the facts of this deemed transaction, OFI had
shown the absence of a principal purpose of federal income tax
avoidance.

Having analyzed the deemed transaction, the Tax
Court found that the end result of OFI's exchange of Wesleyan
Station with Security Bank for the Barnes and Noble Corner was
the same as if OFI had made an exchange of Wesleyan Station with
Treaty Fields followed by Treaty Fields's sale of Wesleyan
Station. The court noted that OFI failed to show that the deemed
transaction lacked as a principal purpose the avoidance of
federal income tax. According to the Tax Court, the only proof
offered by OFI that the transaction was not for tax avoidance
purposes was testimony by OFI's owners regarding the purported
business purpose for reuniting Barnes and Noble Corner with the
rest of Rivergate Shopping Center under the same ownership.
Weighing this self-serving testimony against the large tax
savings OFI would gain from the basis shift in the transaction
if it was treated as a like-kind exchange, the Tax Court found
that OFI had not proved that the transaction was not for tax
avoidance purposes. Therefore, as it had in Teruya
Bros., the court held that the actual exchange was part of
a transaction structured to avoid the purposes of Sec. 1031(f)
and that the nonrecognition provisions of Sec. 1031 did not
apply to the exchange.

Reflections

The court was
very concerned with the issue of basis shifting as an indicator of
a tax avoidance purpose. While the court refused to lay down a
blanket rule that basis shifting equals tax avoidance, it clearly
wanted to close down the opportunity for one party to "cash
out" its lowbasis property through the mechanism of a
like-kind exchange. Taxpayers will need to be prepared to
demonstrate clearly the economic substance of any basis-shifting
exchange with related parties if they hope to overcome the
inference of tax avoidance that the Tax Court appears prepared to
draw.

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